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During the fourth quarter 2012 Apple’s margin fell to about 38%, a level not seen since two years earlier and down from a peak of 47% in Q1 2012. Does this lower margin foretell lower prices or a loss of competitiveness?

Obviously not.

Gross margin is a function of Sales (aka revenues) and Cost of Sales. Gross margin as a percent is calculated with the following formula: (Sales-Cost of Sales)/Sales. If dealing with a single product, Sales itself is the product of shipments and price/unit but since cost of sales is also a product of shipments and cost per unit, the shipments numbers cancel each other out and the gross margin reduces to the ratio of (Price-Cost)/Price.

So a margin drop can only be caused if one of three things happened:

Prices dropped

Costs increased

Both prices dropped and costs increased.

We can easily find out which of these was the cause in the fourth quarter because we have volumes and prices for all of Apple’s products. We can also derive total costs based a total gross margin. These are illustrated in the following retina-friendly diagram.

The diagram shows Revenues, cost of Sales, Operating expenses, Taxes and Net Income relative to each other for the fourth quarters of 2010, 2011 and 2012. Of interest is the difference between 2011 and 2012. Note how the 2012 Gross Margin (absolute, not as a percent, identified with the arrow) did not change much from the year before. As Taxes and Operating Expenses did not change much either, the earnings were quite flat y/y.

However note also that total sales increased quite a bit. As the gross margin (absolute) remained steady and sales increased the margin as a percent fell. But the cause is that cost of sales also increased. They increased faster than sales increased.

Relative to adjusted 4th quarter 2011 Sales increased by 27% while Cost of Sales increased by 30.5%. Margins shrank in late 2012 because the products were more expensive to make.

It’s simple arithmetic.

We can at a glance see that the cost of sales increased as a proportion of sales. Therefore the margin decreased as a percent of sales. The cause is higher costs, not lower pricing.

In fact, pricing analysis was already performed and showed that they largely held steady (iPad being the only decline). If pricing is unchanged then competitive issues are not to blame. The supposed link between lower margins and some mythical loss of competitiveness can be easily disproved.

But there’s more.

There is an easily observed cause to changes in production costs. Consider the opposite effect in the sequential change from the fourth quarter of 2011 to the first quarter of 2012:

Here we can see how sequentially sales fell but gross margins rose. Again, the change in absolute Gross Margin was slight but the reduction in cost of sales was out of proportion of the reduction in sales. Cost of sales fell by 13% while sales fell by 9%. The result was an increase in gross margin from 45% to 47%. The cause was that the cost of production fell.

Obviously. Because, as everyone knows, costs of production fall as output increases. It’s due to something called the learning curve. It’s something that has happened for all of Apple’s (or anyone else’s) product launches forever.

What is not obvious is the effect this has on the share price whose changes are shown at the bottom of the first diagram. It’s a case where one margin’s fall has caused quite a few margin calls.

“Obviously. Because, as everyone knows, costs of production fall as output increases. It’s due to something called the learning curve”.

Nope. that is called economies of scale. The learning curve is about costs falling *over time*, as the manufacturing process matures.

ronin48

Apple purchases components in advance in huge quantities and bank most of the economies of scale very early in new product cycles. It’s part of Tim Cook’s genius.

The products that do gain some cost reductions from economies of scale effects are the lower volume one- or two-generation old products being sold at reduced prices. The lower volumes and reduced prices for these tend tend to cancel out the lower cost of production coming from economies of scale for these items but it allows Apple to lower prices on these and maintain margins. Think of the iPhone 4 and the iPad 2.

So Horace is right. Most of the fall in costs and for new Apple products come from learning curve manufacturing process cost reductions that lead to margin gains.

handleym

True, but one additional point is being missed: The effect on the competition.

The iPhone5 is a ridiculously beautiful item in its utter seamlessness. In that respect it is even more of an improvement on the iPhone4/S than that was on the iPhone1/3G/3GS (where the seams are utterly obvious).

I think the quality of this seamlessness is not yet widely apparent among non-iPhone5 users; but it becomes a little more known every day, as more and more non-users have a chance to look at an iPhone5 closely.

MEANING that, just as competitors initially dismissed the touch screen, and then the retina display, they will at some point have to respond to this manufacturing/design challenge, if they want to continue to be considered in the same league as Apple. And at that point they will have to go through the same pain and cost as Apple has gone through — which means THEIR margins either drop, or they’re in the unhappy position of having to charge more for a product that is, in many ways, inferior (call it the “Surface Pro” problem).

Remember — Apple doesn’t care about the low-end market. Apple’s goal is to make the devices that are most desirable to the upper 30% or so of the market. But Samsung et al can’t respond by ignoring this manufacturing quality issue. In five months, the iPhone 5’s seamlessness moves from high-end to mid-range, in a year and a half to the upper low end. Samsung can try to fight that with 9″ phablets, and (low quality) built-in projectors, and touting technical specs (“now with 16GB of RAM, 8 hyper-threaded cores, and 6 antennas”) but all that means you’re competing for the (minuscule) nerd population, not for the much larger “well off and want nice products” population.

THE issue to watch this year is
– how does Samsung respond to this manufacturing quality?
– how is their response perceived, and what does it cost?
– what does this response cost Samsung?

http://www.filipearaujoribeiro.com/ Filipe Araújo Ribeiro

And why economies of scale exists? Learning curves is one of the reasons. Although I agree with your definition, it seems reasonable and more precise to associate the learning curve concept as the first explanation to understand the falling costs.

http://www.asymco.com Horace Dediu

Improvements in yield are not a function of scale.

http://www.asymco.com Horace Dediu

The Learning Curve model posits that for each doubling of the total quantity of items produced, costs decrease by the same proportion.

Economies of scale apply when costs are reduced due to volume purchases. There is no evidence that Apple’s component prices change during a production run. In fact the reduction in margins typically happens when volumes decrease later in the production cycle. So in effect we have diseconomies of scale.

Walt French

Apple may well be in a region where there are diseconomies of scale. The fall in component prices would be a mix of learning, scale, competitive and other effects.

It’s bleeding edge economics. Apple’s FY13Q1 numbers have that blood all over ‘em. Design, ramp-up reliability, stability of supply, are important up front and a year later, the vendor has it down to a science, many other firms have chosen to design in similar tech and multiple vendors are competing to offer very similar parts. An improved version of the tech appears and everybody re-iterates the cycle, while the older design/part is sold inexpensively, mostly to serve products where cost is more important than newest tech.

tmay

If I’m reading yours and others points correctly, Apple trades margins for a mature and reliable production pipeline, that may see some component discounts over time, with three years looking like the intended lifecycle.

Seems like everybody in the supply chain would be accepting of the stability; the end user gets a discount and might remain attached to the brand at a later upgrade; and Apple has an extremely reliable product that requires almost no overhead to support.

For developers, and accessory suppliers, a longer lifecycle would seem to be especially appealing.

Walt French

Semiconductors, and I presume other high-tech parts, are a minefield for businesses. Very high capital costs, very long lead times, and either a shift in market direction, or a competitor can blindside you.

I’ve been trying to understand the economics behind nVidia’s Tegra line of ARM CPUs, for example. Given nVidia’s long expertise in graphics chips/boards, they designed units specifically to speed Flash. Demo’d with Adobe for quite a while, it wasn’t until the Xoom that they had a major retail product using their chips. And that bombed, in part because Moto was not able to get Adobe to supply a stable Flash implementation despite all the fine engineering. I don’t follow ‘em closely enough to separate Tegra from their other lines, but I presume that most of the sunk development costs have generated very low returns. They’re not headed for bankruptcy, but the market has turned other directions, as neither Samsung nor Apple use it, and the SurfaceRT hasn’t yet made it.

Good company. Good technology. Good bet. Hasn’t worked out that well.

tmay

Walt,

Thanks for the examples.

WRT to “lifecycles”, I’m mainly voicing Tim Cook’s history of pushing the iPhone models down in price at the arrival of a new generation, thus keeping them in production for (up to) 3 years.

http://alexandersmith.co/ Benjamin Alexander

Very very good point.

mieswall

Horace,
Great analysis! Some doubts:
1- Tear-downs of the iphone 5 show that the BOM of the product is just a little higher than ip4s. Given that your analysis shows that most of the cost increase is in fact due to iphone, this would be a further demonstration that the cost is due to:
a) learning curve
b) amortization costs (a miss your comments about this)
The same reasons would explain the unusual high margins of Q1/11, Q2/11, where the iphone4S was in production, almost without learning curve compared with previous product. Hard to repeat, imo, given the somewhat weared-off trick of “S” lines. Market demanding more aggressive products.
Given the above, would you say the problem (supply, yield, learning curve), is mainly an “industrial design” problem, and as such, even being aware of how beautiful Ive’s designs are, his excesses may have a big explanation about the missed sales of holiday Q?

2- Don’t you think that the normal GM could be more in accordance to the average of previous Q’s, but discounting the Q1, Q2/11 margins?

3- Given all these considerations, do you think it is possible for Apple to make a simplified iphone for under-developed markets with margins about those of ipad mini?

handleym

“Hard to repeat, imo, given the somewhat weared-off trick of “S” lines”

Please don’t waste our time with idiot analysis that consists of nothing but repeating the whining of the ignorant on the internet (who, for theological reasons, would never buy an iPhone, but nonetheless feel their opinion on iPhone design is of immense value).

There is ZERO evidence that the “trick” of an S model is in any way problematic or wearing off. The obvious way to bet would be that this year’s model will be a 5S, just like we have seen many times before.

We’ve been through this many times before. ALL of Apple’s products, from iPod to iMacs to minis to MacBooks, have retained their design, more or less closely, for years on end, and across multiple models.

If you’re going to claim that this has been a bad idea, and that Apple plans to change it, the onus is on YOU to prove this claim. You don’t get to simply assert it as obvious.

Henry

I think Horace is right. Learning curve has to do with cumulative production over time. Economies of scale relates to current period production. My sense is that Apple’s costs of any particular product fall with cumulative production.

http://www.asymco.com Horace Dediu

Improvements in yield are not a function of scale.

http://www.asymco.com Horace Dediu

The Learning Curve model posits that for each doubling of the total quantity of items produced, costs decrease by the same proportion. http://en.wikipedia.org/wiki/Experience_curve_effects#Reasons_for_the_effect
Economies of scale apply when costs are reduced due to volume purchases. There is no evidence that Apples component prices change during a production run. In fact the reduction in margins typically happens when volumes decrease later in the production cycle. So in effect we have economies of lack of scale.

ronin48

Great stuff. Accounting 101.

Luis Alejandro Masanti

For a “so secretive” company, you can do a great analysis.

Why do not try it with Samsung, Amazon, Google…?

OOOhhh… I remember, they do not give almost any meaningful number!
Thanks for the analysis.

Ittiam

So Apple stock is poised for a rebound?

speechguys

That all depends on what Wall St wants to do with this type of information.
This is a another clear indicator of fundamentals.

Steve

Do not expect Horace’s analysis of Apple Inc. to have any causal link to AAPL the stock. They are very different, and Horace has stated as much several times. History shows there is no link between facts about Apple and price action on AAPL

stefn

Wall Street feeds on promises, not profits.

Walt French

Umm, that’s funny because it’s true. But not exactly in the way that you characterize it.

If I were to buy one share of Apple, I pay somebody else for the right to receive about one-billionth of whatever Apple pays out to shareholders (because there are about a billion shares outstanding). I also get a one-billionth share of how the company is run. Presumably, I buy those rights from somebody who earlier wanted those rights, but is now happy to take my cash and use it for something else—a trip to the Galapagos, a private yacht, catfood, whatever.

That share conferred to me exactly zero right to tell Cook or Jobs what they did in 2012 or earlier, because that’s impossible. I don’t get any benefit from any past dividends that were made possible by Apple’s enormous success. Strong historical growth of earnings? That’s great insofar as it means money in their Treasury to possibly pay out to me, or to reinvest in even stronger earnings that they’ll pay out some day, or will get somebody ELSE excited to buy my shares from me when *I* no longer want ‘em. But history, ipso facto is bunk worthless, per se. Assuming I’m making a financial transaction for my benefit, I’m doing it because of what I think will happen in the future.

As presumably, the guy who sold the share to me did. Same number of buyers and sellers (or at least, an equal number of shares bought & sold every day). “Wall Street” doesn’t see me coming and gin up some Apple shares out of thin air. They might do it with some new Collateralized Super-Safe Dividend Appreciation Certificates, but now with Apple shares.

stevesup

Yours is the reasonable man theory of the market. Today Mr. Market is a mix of hype and algorithms. A highly irrational blend of emotion and numbers. An insanity unrelated to real work or real people.

Your politics might lead you to distrust any idea from Keynes, but please suspend disbelief long enough to see that the game is rigged — not to favor one party or another, but to make it appear utterly senseless in its day-to-day or perhaps even quarter-to-quarter changes in share prices.

That doesn’t mean that the careful metrics stock analysts (and Horace) apply are meaningless; it means that there can be extended periods where investors worry more about other investors’ impressions; given how uncomprehending even the quite smart, focused individuals here sometimes seem, it’s inevitable that typical traders know less. So many of the billion shares are traded by people who couldn’t begin to tell you Apple’s strategy for handling its biggest marketplace, let alone how they’re building out for what I expect will become their biggest.

I frequently attend finance conferences featuring talks & discussions by the world’s finest financial economists. (Heck, I’ve sat next to two Nobel laureates in the audience!) About the best we can do is to try to understand the motivations and likely behavior by the n00bs who often get the pejorative label, “noise traders” because of their decision-making being driven by random voices whispered into their ears. Amazingly, the truth in the fool and his money notion usually isn’t strong enough to overcome the fact that generally, stock investing is pretty favorable, and the game goes on.

So, yes, there are huge irrationalities, but that’s because of the rules of the game, combined with ordinary human psychology. I wouldn’t necessarily say Wall Street helps very much with these, but the problem is more in our own hearts.

stevesup

I do love a Pogo quote. Once talked with Walt Kelley’s widow to acquire rights to publish some of his material.

Chris

I want to push back on your statement that “If pricing is unchanged then competitive issues are not to blame.” It could be that Apple felt the need to make nicer, more expensive products at the existing price points exactly because of increasing competition. Another way of putting this, which may fit Apple’s style better, is that Apple makes the nicest products it can, but with lower competition would have raised prices, for example selling the entry-level iPhone 5 for $249 fully subsidized instead of $199 in the U.S.

Now, due to your second point regarding production costs over the product cycle, you may well be correct that competitive issues are no more important now than in previous years. But unchanged pricing does not prove this.

ChKen

Increased competition or not, Apple doesn’t make iterative products then fiddles around with retail prices in order to maintain preset margins. They’ve never done that with any of their products that I can recall in the last 10 years. Once a price point has been set, iterative products are always priced at the same level or less than the outgoing product, never more.

Chris

The latest generation of iMacs start at $100 more than the previous generation. The base Mac mini also experienced a price increase in the past decade. It’s even happened with an iOS device: the latest iPod Touch starts at $299 instead of $199.

http://twitter.com/dmarcoot Dave Marcoot

The latest iMac is a new design that is more difficult to manufacture.

Chris

Yes, also true for new iPod Touch. Not saying the price increase isn’t justified, just pointing out that Apple does sometimes raise prices when releasing new versions of products, contra ChKen’s last sentence.

EnGeeYes

I agree that competitive pressure can not be ruled out as a reason for lower gross margin. Another thing to keep in mind is that management guidance for 2013CQ1 calls for 37.5-38.5% gross margin with an implied statement that gross margin estimate is not sandbagged so I am not sure we can expect a substantial margin increase in the CQ1 quarter.

http://www.asymco.com Horace Dediu

You’re suggesting Apple would prefer to raise prices but it has not done so historically with many of its products even if they are upgraded. Only the Mac mini comes to mind.
What Apple does do is create a new price with a higher spec variant. It just did so with the iPad 128 and with the retina MacBooks. The average price is a function of the new price points mixed together. Along with lower points come some higher ones as well.

http://twitter.com/JessiDarko Jessica Darko

The OI&E bar is significantly thicker in the most recent quarter. I think there’s a big story there, since OI&E spending happens prior to product introductions.

I’d like to understand better where the cost of sales increases went. Sure, the learning curve (or ramping up production on fixed equipment costs) lowers costs. But how much of that cost of sales went to the iPad vs the iPhone segments, for instance.

This is something that is very hard to see with this kind of graph which would be easier with a spreadsheet.

poke

The real question is why so many analysts cling to the margin compression story despite there being no sign of price competition. Innumeracy? Ignorance? Malice?

Looking at the pricing, the iPhone looks almost like a product without competition. Carriers have been paying essentially the same premium even while Android has been undergoing huge improvements and gains in marketshare.

ChKen

Laziness.

Relentlessfocus

And arrogance.

rationalchrist

Unbelieve of, stereotype of Apple due to its past. Don’t want or won’t spend time and effort to dive deeper to analysis the data points.

Walt French

It’s a truism of Disruptive Innovation that by the time numbers show you anything, it’s too late to do anything about it.

These clingy analysts may have the story dead wrong*, but I think it’s the right type of thing to be sniffing around.

I would argue most that work on Wall Street are really cheap hookers in drag who pawn themselves off as high class call boys.

Greg

Horace- based on your assumptions a a significant fraction of the rise in costs comes from the iPhone segment.

Yet management expects the gains from the learning curve to be “more than offset by…loss of leverage coming out of the December quarter, which is very typical or [Apple]…and a different mix of current products,” (ie. higher iPad mini volumes).

You cite the transition from calendar Q4 2011 to Q1 2012 as evidence of gross margin rebounds along the product curve, yet management has guided precisely the opposite- suggesting the learning curve is less important than previously. Is management being deliberately conservative?

“In recent years, our guidance reflected a conservative point estimate
of results every quarter that we had reasonable confidence in
achieving. Going forward, we plan to provide a range of guidance that
reflects our belief of what we are likely to achieve. While we cannot
forecast with complete accuracy, we believe we are likely to report
within the range of guidance we provide. Therefore, for the March
quarter, we’re providing revenue guidance of between $41 billion and $43 billion compared to $39.2 billion in the year ago quarter.

We expect gross margin to be between 37.5% and 38.5%, reflecting
approximately $90 million related to stock-based compensation expense. We expect OpEx to be between $3.8 billion and $3.9 billion, including about $480 million related to stock-based compensation. We expect O&E to about $350 million and we expect tax rate to be about 26%.”

jambani

i think that might have come from oppenheimer but the meaning is still the same

Tristram

I believe Oppenheimer comments (above) are the most important of the entire call… and yet, it seems that many have missed them, or at least, interpreted it very differently than I have. (btw, the above comments were from early in the call and he reiterated them later when asked a question about EPS)

For years Apple’s guidance has been significantly below their results, leading to an incredibly wide range of expectations from analysts and thus great uncertainty about earnings. In the last two quarters, they have been unusually close (relative to recent years)… but because of Apple’s past “sand-bagging”, few believed their guidance and thus most analysts predicted significantly higher earnings (etc).

I believe it is now Apple’s very clear intention to start afresh, and to remove the uncertainty from their guidance and to replace it with this new method, a method that allows them a significant amount of freedom, yet still gives their investors a large degree of certainty when evaluating Apple’s guidance.

For the first time ever (?), Apple told us exactly what their earning will be, and from that, exactly what their income and their EPS will be. Using their standard Statement of Operations formula:

As a forum, I ask that we discuss this. Is Apple in fact telling us that we should believe their guidance? Or are they continuing to play the same games as they always have? Please, let’s create a conversation about this!

Horace: Perhaps a column?

EnGeeYes

I think Apple is trying to take control of the wall street expectations game because their previous approach had let things go completely out of control. They want wall street expectations to be within that range and presumably they issue guidance updates later in the quarter if the results are different from their guidance. I like the direction of this change but I think it still doesn’t help with having the stock be valued fairly unless they also provide whole year earnings guidance and guidance updates as well.

Tristram

While I think it would be nice to have multiple quarter guidance, I doubt it will happen. Apple’s business is predicated on secrecy and offering multiple quarter guidance would shatter much of that secrecy.

I agree that part of the reason that Apple is undervalued by investors is because of this uncertainty. With Amazon, or Google, investors know roughly what to expect and they are apparently willing to pay a large premium for this understanding.

Unlike Amazon and Google, Apple has a very large bullseye painted on their back. Their huge margins are desired by many. That scares investors. Amazon and Google, while hugely dominant in their businesses, offer little that the competition can easily take away from them. And thus, even if Apple were able to guide many quarters forward, that uncertainty would remain.

If management has been lying in the past, it’s important that they admit this and state that they will not lie in the future. As far as I can tell they have done neither.

Tatil_S

Admittedly, I never followed the exact phrasing of Appls’s past guidance, but if the difference is predicting just a floor vs. a range with limits on the upside in addition to the downside, their past action is not lying. Are you reading too much melodrama into this announcement?

http://www.asymco.com Horace Dediu

The range they just provided is very narrow, and if we are to believe they will hit within the range then they have a high degree of foreknowledge about what will happen. So what do they know now that they did not know then? If they have the same ability to predict then why did they provide such low numbers in the past? If it’s some new insight into the business, what could it be? Being charitable I would suggest that in the past they did not have a good grip on which operators would place orders when. But since they have not been adding operators lately, perhaps the uncertainty has disappeared.

Tatil_S

Back when? In early 2010, iPad was just coming out and iPhone still had a single model on sale. When iPad was introduced most analysts predicted only a few million to sell before the end of the year. Even the most optimistic Apple centric bloggers were off the mark by a wide margin. Good luck to anybody who could give better guidance for 2010.

The following year when Apple started selling the older iPhone model alongside the new one, it must have been difficult to forecast whether that would bring in new customers or cannibalize sales. Even in summer 2012, some argued that Apple did not know why iPad 2 was still fairly popular. Did consumers just want the cheapest Apple tablet available for sale or did they specifically wanted a cheap 10” tablet but did not care for retina screen? With that uncertainty, it must have been difficult to predict how much iPad Mini is going to cannibalize iPad 2 or appeal to new customers for its smaller size. I am sure by now, the answers to all those questions are much more clear and without a brand new product category, it is much easier to give tighter guidance.

Tristram

Your question is one that intrigues me.

Certainly they do know a great deal more about their new marketplace (handheld computers) than they used to. Additionally, while manufacturing iPods gave them a great deal of experience, phones and tablets are certainly much more difficult to manufacture, and their recent years learning curve was necessary for them to better understand the production process.

I would also venture a guess that there are legitimate ways to move a bit of potential upside into the balance sheet (and “away” from earnings). For example, in the past they have often filled the channel with product, and if they did that here, that would give them a bit more room on the upside… and while likely cause lower margins this quarter, earning and income would be near the top of their guidance and their guidance for next quarter would result in otherwise higher margins (and thus a win-win). FWIW, last year they made mention of that and in their recent earnings call, they reminded us of it again in their sell-through conversation (where they mention they 2.6M iPhones in channel inventory going into Q2’12).

This is, of course, just speculation, and as such, perhaps even wrong minded. Yet I see many, many more advantages for Apple to report in line with their guidance then to radically over or under shoot it. While they have (apparently) taken a great risk by radically narrowing expectations, letting expectations run wild as they have over the years has proven very dangerous to their company:

An highly under valued stock is bad for a number of reasons, and frankly, the one that may concern them most is employee retention. Bringing expectation into line with performance may not stabilize their stock, but it will go a long way to help mitigate one of the uncertainties of owning the stock, and that is likely to do far more good than harm.

mieswall

I’m not so charitable. Perhaps it is due that they already sold their shares at a much better price, and maybe used the money to trade options. No need to lie now, a predictable share movement would be better for untouched strikes.

GuruFlower

@ Tristram

I believe one adds OIE to the Operating Income, not subtract it. Doing that I calculate the range of Net Income Apple expects for FQ2 2013 is 8.75 billion – 9.70 billion.

What no one seems to have mentioned in the countless reviews of Apple’s guidance since January 23rd is that these numbers are significantly below FQ2 2012 Net Income. In FQ2 2012 Apple reported Net Income of 11.622 billion. Thus, their best case scenario indicates a decline in Net Income of 1.92 billion (-16.56%) from a year ago. (I’m not projecting EPS since that is dependent on the number of shares outstanding.)

Absent news of a major new product announcement prior to reporting numbers like these, a YOY decline in income could be a disaster for the share price. In fact, it has already been a disaster for the share price.

http://www.facebook.com/mani.ghasemlou Mani Ghasemlou

One possibility for lack of EPS number is that they do not know what their shares float will be due to an acceleration of their stock buyback program.

It is possible that they intend to buy back shares of their company faster than we expect in the weeks/months/years ahead, to the extent that they decided to leave out the EPS calculation from their guidances.

Perhaps I am reading too much into it. Just putting this possibility out there.

GuruFlower

Possibly, but they would have to buy back an enormous number of shares to beat EPS from a year ago (12.45) with the guidance they are giving.

http://www.facebook.com/mani.ghasemlou Mani Ghasemlou

Does Oppenheimer have the ammunition to buy back an “enormous number of shares” ?

After glancing at their cash flow + cash/equivalents on b-sheet, one would think this is at minimum theoretically possible.

Tristram

In their Q1’13 10-Q, they state that through the ASR they bought back 2,582,782 shares between Sept 30 and Nov 3 of last quarter. Separately they say they authorized $1.95B for FY13, and I believe we can assume the shares were bought with this money. If the shares were purchased at the lowest fair market value during Oct last year (which of course is a ridiculous generous assumption), that means they already spent more than $1.5B of the $1.95B… and thus, without authorizing an additional ASR program, the outstanding share count is not likely to deviate significantly outside its current bounds.

Said another way, based upon historic trends, it is likely that the outstanding shares for Q2’13 will be roughly 946M – 949M shares. And thus, share count will likely change very little quarter over quarter.

Even if they authorize another $2B chunk for the ASR, it still wouldn’t effect the share count by more that 4.5M shares (and thus roughly no more than +/- $.05 EPS).

The genius of their new system of offering guidance is that it does in fact give them a lot of room to maneuver… yet it still offers a very real limit to what we can (reasonably) expect in earnings, income, and EPS (etc). With the new system, we can now compute, plus or minus a couple dimes, what the upper and lower limits of EPS will be. And while this may take away most of the fun of guessing their earnings, it will allow investors to maintain reasonable expectations of earnings. Their previous “system” clearly didn’t work: the truth is, going into earnings, none of us had any idea what to expect. With the new system, we now know. I for one, am thankful for this change.

mieswall

yes Mani.

Pair that with the big change in the liquidity, proportion of cash / LT investments this Q, and maybe we are two that are reading too much

But I’m not yet convinced that there is anything “more realistic” about revenue. The phrasing went from “having reasonable confidence in achieving” to “believing that they will report within”. Bear in mind that if they admit they were deliberately lying in the past they are liable.

Tatil_S

Only a floor vs a floor and a ceiling to keep analysts from predicting the heavens and then declare it a miss?

http://www.asymco.com Horace Dediu

Analysts predicted way above the guidance and were still way off. The error rates on earnings were awful even when they were sandbagged.

Walt French

They promised, and delivered, a tight range of guidance instead of a (universally presumed to be sandbagged) point estimate. So tight as for me to wonder what could possibly have changed that they understand the future so much better.

To the extent that they deliver un-manipulated results in the very tight range (versus the wide range of variance on past guidance), then it will be “more realistic.”

I don’t imagine this combo of ultra-tight projections, followed by presumably within-band results, can continue.

Tatil_S

Well, there are many ways to manage earnings to smooth out the unexpectedly good and bad results. Some attribute at least some of GE’s success in keeping its stock price on that long upwards trajectory during Welch years to such an effort. Wall Street loves predictability. If you don’t deliver the expected numbers, your stock gets punished. If you go above and beyond every now and then, your stock may jump a bit, but not as much as a pure TTM P/E based analysis would suggest.

Walt French

Correct me if I’m wrong, but Apple guidance is ONLY re revenues; manipulation pretty much off the table.

Tatil_S

They forecast gross margin, OpEx and tax rates, as well as revenues. All could be managed to some extent if there is a desire to do so.

Even on the revenue side, just crudely delaying shipments by a week could give you a 7% wiggle room, which is $3 billion when the guidance is for $42 billion. If you think Wall Street would punish you for reporting $45 and $39 billion sequentially, it might be tempting to try to get a $42 and $42. Similarly, you can incur costs a little early to smooth out earnings from a quarter that could be lackluster into a better one. That is probably less efficient, less optimal overall for the operations of the company, but many companies entertain such moves to some extent. This is all before varying the accounting classifications if there is a grey area around what can or cannot be booked for this quarter or next. Of course, it is always easier to obscure the success of a quarter than hide the shortcomings of a bad one, but nevertheless it is an option.

Walt French

Thanks for the correction.

Regards your smoothing example, the SEC has indeed questioned cookie-jar accounting, where a bump in sales, and the attendant profits, get set aside for a rainy day. I believe that Apple has gotten more realistic in their own “realization” of business.

http://www.asymco.com Horace Dediu

I believe that the knowledge management had about their own future performance is the same now as it was under the previous guidance methods. I also believe they knew what would happen with a high degree of precision since production plans and component pricing were set well in advance of guidance.

Walt French

I think you’re saying that they have committed to stopping sandbagging. Perhaps last qtr was an obviously flawed move in that direction, as analysts didn’t get the message, and they’re going to Accuracy 2.0, all while avoiding the question of whether they’ve stopped beating their partners.

gbonzo

CQ4 2011: 37m iPhones
CQ1 2012: 35m
CQ2 2012: 26m
CQ3 2012: 27m

Obviously, they could have made 35 million or more units in those quarters when they only made and sold 26 and 27 million. They had capacity to do that as they already did that in two consecutive quarters.

Why they chose not to? Demand.

So, Apple throttles production based on demand. That is a fact.

I believe Apple is a clear leader in inventory management and utilization of Just In Time production. Why do you keep insisting that production plans are set well in advance of guidance?

mieswall

I believe this new guidance procedure is just a strategy to bypass the fact that for the first time in years Apple will have a negative growth. That way, they didn’t have to declare a guidance lower (much lower in fact, because of the sandbagging issue) than previous year.

The market reaction, although, was the same that they were trying to avoid.

http://www.asymco.com Horace Dediu

Bypass the fact? Apple guided for negative growth in October as well.

Justsaying

The core issue is Apple grew phones only ~20% while margin dropped ~ 20% despite having launched iphone 5 in many more countries incl. China in launch qtr. The phone volume ought to have been bigger but wasn’t due to either lower demand or production issues. Since forecast isn’t showing great growth, it was likely a combination of both meaning demand has soften. Cook in earnings call wouldn’t disclose iphone customer profile between new users and upgrades – a number they normally share proudly. Perhaps new users in EM is slowing as they choose android.
Looks to me Apple is going thru a few tough quarters with poor YOY growth but will recover in Fall if china mobile launch and lower cost phones get launched. ATT and Verizon volume show their us customer base is loyal.

http://www.asymco.com Horace Dediu

Do you have a link to a proudly shared disclosure of the iPhone “customer profile”?

Walt French

@asymco:disqus wrote, “If pricing is unchanged then competitive issues are not to blame.”

Just to quibble, it could be that competitive issues caused Apple to stuff in more features/components in order to keep volumes at the same selling price. If that were the case — I’m talking abstractly here — that’d have the same effect as having to cut prices on existing configurations to keep market share.

http://www.asymco.com Horace Dediu

“We’re keenly aware that when we develop and make something and bring it to market that it really does speak to a set of values. And what preoccupies us is that sense of care, and what our products will not speak to is a schedule, what our products will not speak to is trying to respond to some corporate or competitive agenda.” – Jony Ive

Yes, I believe Apple does this as consciously and purposefully as any big firm.

But I don’t think it speaks to pricing or the timing of adding the iPad/128 to the lineup. Or Apple’s just-barely-enough provisioning of RAM for its products, which it’s done for decades. These are price point decisions that many read as planned obsolescence.

jambani

i wrote this below as well. If improving the learning curve is all that is needed to improve gross margins, then why is their sequential guidance (which should be close to what they really expect) for the March quarter so low?

http://www.asymco.com Horace Dediu

Again, please check the history of guidance from the fourth quarter into the first.

I read somewhere about how apple pays back their distributors, as part of their technique to keep the retail price the same everywhere.

Wouldn’t higher costs here, mean that they have paid more to distributors this year (telcos, stores),

which is quite similar to apple selling cheaper to ‘their’ customers ?

Also, what about inventory build up ?

Which delay between recognizing costs of building devices and recognizing the sale ?Somehow some costs in one quarter result in sales in the next, and this amount changes each quarter. Don’t know how big this can be.

If such a delay exists, and there have been production constraints, this could mean many parts have been purchased in Q4, product sold in Q1. Production contrains / surprises could be just 1 part missing, but all the other already purchased waiting for assembly – with the pressure from stores, they don’t necessarily run zero stock manufacturing ?

Mark_A_T

These “later sales” shouldn’t have any effect at all.

For every single product produced, it only appears in “cost of sales” once it has been finished and sold. Until then, it remains on the Balance Sheet as “Inventories”. Have a look at that line item and you’ll see it rose Sep (791M) – Dec (1,455M) by 84%.

Horace, I read a lot of different web pages and had heard some where that Apple was moving towards a 6 month refresh cycle for the iPhone and iPad. The iPad was the first to do this with the surprise update to the iPad (3) which is now called the iPad 4. This idea makes a lot of sense after the success of the Galaxy s3 last summer. Apple was still running the 4s which had been introduced back in fall 2011. Last summer was the first surprise drop in Apple’s income and this appeared to be mainly due to reduced sales from people either holding off and waiting for the iPhone 5 or jumping on the new Galaxy 3s. Cap ex was also much higher than it had been traditionally. Wouldn’t shifting to a faster update cycle on the iPad and iPhone explain a lot of the Cap EX increase you saw late last summer? You were expecting a very large increase in sales and were somewhat unsure in your guidance as noted in your post about almost holding back on putting out your earnings estimates. Perhaps Apple has changed some of it’s methods of doing business based upon the increased level of competition from Samsung. Ramping up additional products per year would have the effect of pushing down the benefits from the learning curve because more model choices leads to less production per model of phone.

I was also surprised to hear that Apple has already allocated some of their cash to pay for taxes if the money is repatriated back to the US. Does any one have a break down of how much of Apple’s current cash on hand is already expensed our as taxes due for bringing profits back to the US or software support. Cash flow in Quarter 1 2013 was back to the healthy surplus we have been seeing during the last several years. Q4 2012 (financial not calendar) cash flow seemed much weaker, with less excess cash on hand.

twilightmoon

I have heard nothing credible indicating that Apple I intends to waste its foreign cash holdings to repatriate in order to pay more in dividends. It might be able o use some of it to buy back some of its own stock to offset the cost of employee options.

I would expect they plan to use that money to leverage other companies for favorable raw materials, manufacturing or shipping costs.

handleym

“and had heard some where that Apple was moving towards a 6 month refresh cycle for the iPhone and iPad. ”

Let’s believe this when we have some evidence for it…
A more reasonable explanation for the iPad3/iPad4 business was that Apple WANTED to ship the iPad3 with the A6, but something delayed that (chip yields? a last minute design bug). However, being a sensible company, they had a backup plan in place which they activated.
In other words the iPad3 was a one-off anomaly, not the harbinger of shorter product cycles.

Apple has done very well out a largely annual upgrade cycle, with only occasional variants to meet unusual circumstances. Why would they give this up for the dubious benefits, and very obvious costs, of faster refresh cycles?

D

Hmm, think you’re forgetting about mix here. I’m pretty sure lower mac sales combined with higher iPad sales (and within iPad some cannibalization on lower margin iPad minis), is a large part of what is going on here…

Let us say I bought a single share of AAPL on 22 Jan at 504.77 (it’s closing price that day) and then received a 2.65 dividend. Assume I held that share of ownership for perpetuity, and assume Apple continued paying the same dividend.

It would take me almost 48 years to break even on my investment!

Why own a share of ownership if you aren’t receiving a return of the profits of that company? Speculation. Gambling. Hoping to ride or beat The Insanity of the Crowd.

Share prices have been completely divorced from company’s actual performance for a very long time. All of the pricing “rules” were polite fictions. It’s only now that it affects Apple speculators that anyone cares.

iwod

Well it is Number 3. Both prices dropped and costs increased. Historically every single new generation of iPhone, ( Non S ) version has costed more. That is because more Hardware features, and parts are fitted in. Comparing the Margin of an iPhone 5 to iPhone 4S makes absolutely no sense at all. And the Price for components would gradually drop as yield rate and shipments improves. Looking at the BOM one would notice the LTE Baseband + Receiver cost nearly doubled then iPhone 4S. That is $15 – $20 increase in production cost. There is also the price increase switching from 45nm to 32nm.[1] If past estimate were any guidelines a 16GB used to cost $149 – $199. All else being equal $15 – $20 dollar increase in BOM would have cut the margin to somewhere around the Apple’s current report.

The Cheaper Pricing were simply iPad Mini eating into iPad territory.

The future Qualcomm WTR1605 and MDM9x25 should be some what cheaper due to its decrease in total package area. Along with better yield, and improvement the S should rise the margin again.

Ok……. Um….. haven’t we been through this talk 2 years ago? Oh well i guess Wall Street need an excuse to bring down Apple’s stock price for future use.

Note [1] While 32nm is more expensive, given the A6 die size is smaller the cost should be around the same.